Question

At time zero the spot rate is $1.60 per GBP. Assume that next year the U.S. inflation will be 3 %, and British inflation 4%, what is the expected exchange rate at year end?

Answer: $1.5846/GBP

Assume that next year the U.S. inflation will be 3 %, and British inflation 4%. And the British Pound depreciates 7 % over the year. What is the real exchange rate q, at year end?

Answer: ???

Answer 1

Spot rate 1 GBP =	$                    1.60
Inflation in U.S. =	3%
British inflation rate =	4%
Forward rate = 1.60 * (1+0.04)/(1+0.03)
$1.5846
GBP Actual depreciation rate =	7%
If one currency, percentage is adjusted in reverse currency/opposite currency from spot rate.
Spot rate 1 GBP =	$                    1.60
Less : Depreciation 7%
Real exchange rate = 1.60 * (1-0.07)=	$1.4880
So, real exhange rate is 1GBP = $1.4880.